Indirect short-selling constraints

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In this thesis, I use two strategies of inquiry to further our understanding of indirect
short-selling constraints. First, I interview a series of experienced market
practitioners to identify their attitudes towards indirect constraints. I find little
support for D’Avolio’s (2002) suggestions that short-selling is inhibited by
managers’ fear of tracking error and by the cultural pressures of a society that can
vilify short-sellers. However, I am able to introduce a new, social, indirect constraint
to the literature – the perception that short-selling is a form of ‘trading’ as distinct
from ‘investment’, and the consequent lack of acceptance amongst stakeholders that
this engenders. This constraint reveals a divide between the attitudes of the academic
community and parts of the institutional practitioner community on the subject of
short-selling. However, interviewees argue that this indirect constraint is diminishing
over time. This raises the prospect of markets in practice converging in behaviour
towards the markets assumed in classical asset pricing models, and has implications
for market efficiency. My second strategy of inquiry is to use a large, new stock
lending database to explore three risk-related indirect constraints to short-selling. I
examine ‘crowded exits’, a general class of liquidity problem, and find that these are
associated with statistically and economically significant losses for short-sellers. I
also examine ‘manipulative short squeezes’, a liquidity problem arising from
predatory trading. Consistent with theory and the literature on the subject, I find that
these are rare for larger, more liquid stocks. However, when they do occur, these
events generate statistically significant losses for short-sellers. Finally, I build upon
the work of Gamboa-Cavazos and Savor (2007) and investigate the response of
short-sellers to losses. I find that short-sellers close their positions in response to
accounting losses and not simply in response to rising share prices. This is consistent
with short-sellers’ use of risk management tools that are designed to crystallize small
losses. These serve to limit the risk of potentially unlimited losses and to reduce short
positions at times of heightened synchronization risk. Stocks subject to shortcovering
in this manner do not subsequently under-perform the market. My findings
demonstrate that a sophisticated group of traders, strongly associated with price
setting, does not suffer from the bias known as loss realization aversion.